Implementing IFRS 9: a guide for lessors Implementing IFRS 9: a guide for lessors

IFRS 9 brings together the classification and measurement, impairment and hedge sections of the IASB’s project replacing IAS 39 Financial Instruments: Recognition and Measurement and all previous versions of IFRS 9. IFRS 9 is effective for annual periods beginning on or after 1 January 2018 and will have a significant impact on lessors, specifically in relation to the following areas:

1. Classification and measurement 2. Impairment of financial 3. 4. modification clarification

For more insights see www.eyfs.ie/aviationfinance

1 1. Classification and measurement

IFRS 9 introduces a new model for classifying financial assets. In respect of financial liabilities, all IAS 39 requirements have been carried forward to IFRS 9.

The standard introduces principle-based requirements for the classification of financial assets, using the following four measurement categories: i. Debt instruments at amortised cost ii. Debt instruments at through OCI (FVOCI) with cumulative gains and losses reclassified to profit or loss upon derecognition iii. Debt instruments, derivatives and instruments at FVTPL iv. Equity instruments designated at FVOCI with no recycling of gains and losses upon derecognition

The classification of financial assets is summarised in Illustration 1 below.

Debt (including hybrid contracts) Derivatives Equity

‘Contractual flow characteristics’ test (at instrument level) Pass Fail Fail Fail

‘’ test (at an aggregate level) Held for trading?

1 Hold-to-collect 2 BM with objective that results 3 Neither (1) Yes No contractual in collecting contractual cash nor (2) cash flows flows and selling financial assets

Conditional fair value option (FVO) Yes FVOCI option elected? No elected? No No Yes

Amortised FVOCI FVOCI FVTPL cost (with recycling) (no recycling)

Illustration 1 – classification of financial assets

2 The typical financial assets held on the of lessors impacted by IFRS 9 include the following;

Name IAS 39 classification IFRS 9 classification

Unrestricted and restricted cash Amortised cost Amortised cost

PPN assets Amortised cost FVTPL

Derivative financial assets FVTPL FVTPL AFS assets/Investments at FVOCI FV through OCI

Amounts due from related parties Amortised cost Amortised cost

Trade receivables Amortised cost Amortised cost

Loans/Notes receivable* Amortised cost Amortised cost

*Assuming collecting principal and only.

The above assets held at amortised cost under IAS 39 should, the impact of this change in measurement will disappear based on the typical fact pattern of these assets, meet the on consolidation. This will still need to be considered in the business model test, in that they are held to collect contractual standalone financial statements of the entity holding the PPN cashflows and these cashflows are solely payments of principal assets, or indeed in the company balance sheet of the parent and interest (‘SPPI’). Hence, lessors will continue to account if the parent company balance sheet requires inclusion in the for these assets at amortised cost, with the exception of PPN financial statements. assets. The assets accounted for as “AFS” under IAS 39 will typically PPN assets typically entitle the holder to the residual returns be categorised as FV through OCI under the business model in a structure in exchange for the most subordinate class of test. This new category has similar objectives to the IAS 39 debt in a structure and as such are akin to equity returns. As category, the objective being collecting contractual cash flows a result, PPN assets will be measured at FVTPL as the above and selling financial assets with those contractual cashflows conditions (SPPI) of the business model test are not met. Many meeting the SPPI test. Those assets which were previously groups will include these assets as part of their structure. classified as FV remain being classified as FV. In the majority of instances, given the structuring of PPN assets by most lessors through the group but not externally,

3 2. Impairment of financial assets

The new impairment model in IFRS 9 addresses the IASB’s key 1. General Approach concern that the “incurred loss” model in IAS 39 contributed The general approach will be applied to all loans and to the delayed recognition of credit losses which arose as a receivables not covered by another approach. In practice for result of the financial crisis. Therefore, the new impairment lessors, it is not expected that cash will be considered for requirements are based on a forward-looking expected credit impairment. Therefore, lessors will apply this approach to the loss (ECL) model. following financial assets: IFRS 9 defines credit loss as the difference between all • Investment at FVOCI contractual cash flows that are due to an entity in accordance • Amounts due from related parties with the contract and all the cash flows that the entity expects to receive (i.e., all cash shortfalls), discounted at the original • Loans/Notes receivable EIR. It goes on to define ECLs as ‘the weighted average of Under the general approach, entities must recognise ECLs in credit losses with the respective risks of a default occurring as two steps as illustrated below. the weights’. The expected cash flows will include cash flows from the sale of collateral held or other credit enhancements For credit exposures where there has not been a significant that are integral to the contractual terms. increase in credit risk since initial recognition (i.e., ‘good’ exposures), entities are required to provide for credit losses In applying the IFRS 9 impairment requirements, an entity that result from default events ‘that are possible’ within the needs to apply one of the following approaches: next 12-months (a 12-month ECL – stage one in the illustration 1. The general approach below). For credit exposures where there has been a significant increase in credit risk since initial recognition, a loss allowance 2. The simplified approach is required for credit losses expected over the remaining life 3. The credit adjusted approach of the exposure, irrespective of the timing of the default (a The credit adjusted approach will most likely not apply lifetime ECL – stages two and three in the illustration below). to lessors and has not been discussed in this paper. The The loss allowance reduces the carrying amount of the application and impact of the remaining two approaches for financial in all three stages described below. lessors have been discussed below.

Stage 1 Stage 2 Stage 3

Loss allowance updated at 12-month ECL Lifetime ECL each reporting (credit losses that result date from default events that are possible within the next 12-months)

Lifetime Credit risk has increased significantly ECL since initial recognition criterion (whether on an individual or collective basis) + Credit-impaired

Interest Effective Interest Rate EIR on gross EIR on gross (EIR) on gross carrying carrying amount amortised cost recognised amount (gross carrying amount less loss allowance)

Change in credit risk since initial recognition Improvement Deterioration

Illustration 2 – General approach for impairment of financial assets

4 So what does this mean for lessors in practice and how can The ECLs in respect of financial assets held at amortised cost a lessor identify whether a 12 month of lifetime ECL should are recognised as a loss allowance against the gross carrying be applied? amount of the asset, with the resulting loss being recognised in The first consideration is to assess what in practice would profit or loss. evidence a significant change in credit risk. Firstly any arrears For debt instruments measured at FVOCI, the ECLs do not greater than 30 days past indicate a movement to stage two. reduce the carrying amount in the statement of financial For a lessor holding assets with counterparties who have credit position, which remains at fair value. Instead, an amount equal ratings (or where counterparties liabilities themselves have a to the allowance that would arise if the asset was measured rating), a deterioration of the credit rating of the counterparty at amortised cost is recognised in OCI as the ‘accumulated would indicate a movement to stage two. Other indicators impairment amount’. This means that impairment losses (or include: reversals) are charged to profit or loss with a corresponding • Existing or forecast adverse changes in business, financial or entry in OCI. economic conditions that are expected to cause a significant Collateral is not considered when assessing whether a change in the borrower’s ability to meet its debt obligations. is classified as stage one, two or three; • An actual or expected significant change in the operating however, collateral can be considered when considering what results of the borrower. impairment provision should be applied. • An actual or expected significant adverse change in the regulatory, economic, or technological environment of the 2. Simplified Approach borrower. The simplified approach is required for certain qualifying trade • Significant changes, such as reductions in financial support receivables, IFRS 15 contract assets and lease receivables. from a parent entity. IFRS 9 allows the use of a provision matrix as a practical • Significant changes in internal price indicators of credit risk expedient for determining ECLs on trade receivables. Many as a result of a change in credit risk since inception. corporates may already use a provision matrix to calculate In many instances there may be limited information available their current impairment allowance, but they will now be for a counterparty. The standard is clear that in certain required to consider how they can incorporate forward-looking circumstances, qualitative and non-statistical quantitative information into their historical customer default rates. Entities information may be sufficient to determine that a financial would also need to group receivables into various customer asset has met the criteria for the recognition of lifetime ECLs. segments that have similar loss patterns (e.g. by geography, product type, customer rating or type of collateral). Once a lessor has assessed whether 12 month or lifetime For lessors, their financial assets under this approach will ECL is appropriate, how is the impairment charge have significant collateral in the form of security deposits and calculated? maintenance reserves (for trade/lease receivables). Many large financial institutions already have sophisticated expected loss models and systems in place for capital The impairment disclosures have been expanded significantly adequacy purposes, capturing data such as the probability of in comparison to the existing disclosures required under IFRS default (PD), loss given default (LGD) and exposure at default 7. The objective of the new disclosures is to enable users to (EAD). understand the effect of credit risk on the amount, timing and uncertainty of future cash flows. We do not expect many lessors to have models and systems in place that capture such information. For financial instruments The disclosures should provide: that are rated, for example, listed bonds, an entity may be able to use historical default rates implied by the external credit • Information about the entity’s credit risk management ratings. Another possibility is the use of credit default swap practices and how they relate to the recognition and (CDS) spreads and bond spreads. In addition, an LGD of 60% is measurement of ECLs. commonly assumed for listed corporate bonds. • Quantitative and qualitative information that allows users of Measurement of ECLs is even more difficult and judgmental financial statements to evaluate the amounts in the financial if the financial asset is not rated and no market observable statements arising from ECLs. information is available. In that case, the entity would be • Information about the entity’s credit risk exposure, required to estimate the reasonably possible loss scenarios i.e., the credit risk inherent in its financial assets and and the respective probabilities, to arrive at an unbiased and commitments to extend credit, including significant credit probability-weighted amount that reflects the time value of risk concentrations. money. This estimation should be based on reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions.

5 3. Hedge Accounting 4. Debt modification

The objective of IFRS 9 for hedge accounting is to reflect the IFRS 9 provided a clarification on the treatment of modified effect of an entity’s risk management activities in the financial debt. IAS 39 and IFRS 9 regard the terms of exchanged or statements. This includes replacing some of the arbitrary rules modified debt as ‘substantially different’ if the net present with more principles-based requirements and allowing more value of the cash flows under the new terms (including hedging instruments and hedged items to qualify for hedge any fees paid net of any fees received) discounted at the accounting. original effective interest rate is at least 10% different from the discounted present value of the remaining cash flows of In general, for lessors, hedge accounting is non-complex and the original debt instrument. This comparison is commonly highly effective. We would not expect lessors to apply hedge referred to as ‘the 10% test’. accounting to relationships where hedge accounting was previously not allowed. Whilst IAS 39 and IFRS 9 do not say so explicitly, it seems clear that the discounted present value of the remaining cash The following are the key changes to hedge accounting under flows of the original debt instrument used in the 10% test IFRS 9: must also be determined using the original effective interest • Hedge effectiveness testing is prospective only and can be rate, so that there is a ‘like for like’ comparison. This amount qualitative depending on the complexity of the hedge. The should also represent the amortised cost of the liability prior to 80-125% range is replaced by an objectives-based test that modification. focuses on the economic relationship between the hedged For entities applying IFRS 9, which is effective from 1 January item and the hedging instrument, and the effect of credit 2018, the treatment of changes to the contractual cash risk on that economic relationship. flows of a financial liability that is not derecognised has been • IFRS 9 allows risk components of non-financial items to be considered by both the Interpretations Committee and the designated as the hedged item, provided the risk component IASB. Of particular relevance to them is the fact that IFRS is separately identifiable and reliably measureable. Under 9 requires modification gains or losses to be recognised in IAS 39, this was only possible for financial items or when profit or loss when the contractual terms of a financial liability hedging foreign exchange risk. measured at amortised cost are changed and those changes • IFRS 9 introduces the concept of costs of hedging. The do not result in derecognition of the liability. time value of an option, the forward element of a forward Historically, many lessors did not recognise this gain/loss contract and any foreign currency basis spread can be on modified debt which under IFRS 9 has been clarified as excluded from the designation of a required. As a result, any previous modification of a liability as the hedging instrument and accounted for as costs existing on the transition date of 1 January 2018 will have of hedging. This means that, instead of the fair value to be assessed to calculate the transitional impact as IFRS 9 changes of these elements affecting profit or loss like a is required to be applied retrospectively. This will be adjusted trading instrument, these amounts are allocated to profit through opening retained earnings. Following transition, any or loss similar to transaction costs (which can include basis gains/losses arising from debt modifications will be taken adjustments), while fair value changes are temporarily through the . recognised in OCI. • More designations of groups of items as the hedged item Although the effect of IFRS 9 is not as great on non-financial are possible, including layer designations and some net entities, the impact of adopting IFRS 9 should not be positions. underestimated. Should you have a question in relation to any of the points above please reach out to Pat O’Driscoll.

Contact

Patrick O’Driscoll Director, Aviation Finance E: [email protected] T: +353 1 2212 771 www.eyfs.ie/aviationfinance

6 EY | Assurance | Tax | Transactions | Advisory

About EY

EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organisation and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organisation, please visit ey.com. © 2018 Ernst & Young. Published in Ireland. All Rights Reserved. 75407.indd 09/18. Artwork by the BSC (Ireland) ED none The Irish firm Ernst & Young is a member practice of Ernst & Young Global Limited. It is authorised by the Institute of Chartered in Ireland to carry on investment business in the Republic of Ireland. Ernst & Young, Harcourt Centre, Harcourt Street, Dublin 2, Ireland. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. eyfs.ie